The curious rise of high-yield bonds

The bond party is on — investors are enjoying fixed income these days. According to the Investment Company Institute, bond-fund flows picked up sixfold in the first week of May over the last week in April. Economic growth is so slow that there doesn’t seem to be much immediate danger from interest rates, though that could be problematic for shakier businesses at some point.

But the zeal with which some investors have embraced high-yield bonds has raised some eyebrows. High-yield bonds are rated below investment grade by ratings agencies such as Fitch and Moody’s. They’re inherently speculative, but the risk of default is historically paid for by generous returns. In these dark days of low interest rates, those returns have dried up. Investors get all of the risk with a fraction of the reward.

Yields and default rates are low

Just about any company can get rock-bottom loans from investors now, and at today’s rates, making the coupon payments is no problem for even the wobbliest enterprises. Corporate defaults on high-yield debt hit a recent low point in the first quarter of 2014 — 1.7 percent, the lowest since February 2008, Moody’s reported in April. The long-term average since 1983 is 4.7 percent, according to the ratings agency.

Above is a chart of the Bank of America Merrill Lynch U.S. High Yield Master II Option-Adjusted Spread from the Federal Reserve Bank of St. Louis. The chart shows the narrowing spread between junk bonds and a Treasury spot rate curve. (The spot rate curve is used to value bonds by adding up the rates of individual coupon payments.) In essence, the chart reveals that the difference in yield between triple-A rated Treasury bonds and below-investment-grade junk bonds is negligible.

It’s no secret that the Fed’s low interest rate policy has pushed investors toward riskier assets, and low corporate default rates combined with the recent performance of bonds has tempted plenty of investors into the more speculative areas of the bond market. According to a recent story in The Wall Street Journal, “Chasing yield, investors plow into riskier bonds,” large investors are behind the recent inflows, but small investors could be pulled into the fray in their hunt for yield.

The question is, does the compensation make up for the added risk? Many people say no. Debt investors threw money at the French cable company, Numericable, last month, the Financial Times website reported at the end of April in the story “Junk bond fever hits new high with jumbo Numericable deal.”

From the story:

Investors have been particularly emboldened by low corporate default rates, which are running at half the historic average of about 4 percent.

“There is this sense we are running out of things to invest in — it’s a bit like the London property market. I don’t have a strong view what will end this — but it does feel as though we are not pricing in default risk adequately enough,” says (Kevin) Corrigan, (head of credit) at Lombard (Odier Asset Management).

So you shouldn’t buy high-yield bonds?

Interest rates are at all-time lows in general and most savers and investors are frustrated by the yields in savings vehicles and high-quality, short-term bond funds.

“I think if someone wanted to include a small allocation to the Vanguard High Yield Corporate fund, that would be fine. But the reason I don’t recommend them is they are a hybrid security,” says Certified Financial Planner professional Jonathan Duong, CFA, founder and president of Wealth Engineers in Denver.

“They are not a replacement for the bond portion of your portfolio. You get high volatility and significant risks the way you would with stocks; it makes the asset allocation harder,” he says.

They can be tricky from a tax perspective as well.

“You have current income that is generated, which suggests they would fit in an IRA or retirement account, but you also get significant capital gains, which would argue for a taxable account,” Duong says. Capital gains are generally taxed at a lower rate than income.

Duong recommends skipping high-yield altogether and instead splitting that allocation between high quality stocks and bonds to “get to the exact same place.”

Maybe the recent hand-wringing over the popularity of junk bonds is just Chicken Little proclaiming the sky is falling. But with an interest rate increase somewhere on the horizon, both rates and the default rates of shaky companies may have nowhere to go but up.

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